Chapter 1

Introducing Financial Modeling

IN THIS CHAPTER

Exploring the who, what, and why of financial modeling

Investigating different types of models

The demand for financial modeling skills has increased exponentially in recent years and many job listings for finance positions now include “financial modeling” as a core skill. If you’re reading this book, you’ve probably already discovered how important this skill is, and you know that learning financial modeling will increase your employability in finance or financially focused fields.

In this chapter, I define financial modeling — what it is, who uses it, and why it matters. I also show you some examples of financial models. If you’re brand-new to financial modeling, this chapter is a very good place to start.

Defining Financial Modeling

Before you dive into how to use Microsoft Excel to create financial models, you need to know what financial modeling is, who uses financial models, and why financial modeling matters. In this section, I fill you in.

What it is

When I teach a course on basic financial modeling, I always ask my students for their definitions of the term financial model. Most of them come up with long-winded descriptions using terms like forecast and cash flow and hypothetical outcomes. But I don’t think the definition needs to be that complicated. A financial model is a tool (typically built in Excel) that displays possible solutions to a real-world financial problem. And financial modeling is the task of creating a financial model.

You may have thought that a financial model was basically just an Excel spreadsheet, but as you probably already know, not every spreadsheet is a financial model. People can and do use Excel for all kinds of purposes. So, what makes a financial model distinct from a garden-variety spreadsheet? In contrast to a basic spreadsheet, a financial model

• Is more structured. A financial model contains a set of variable assumptions — inputs, outputs, calculations, and scenarios. It often includes a set of standard financial forecasts — such as a profit-and-loss statement, a balance sheet, and a cash flow statement — which are based on those assumptions.
• Is dynamic. A financial model contains inputs that, when changed, impact the calculations and, therefore, the results. A financial model always has built-in flexibility to display different outcomes or final calculations based on changing a few key inputs.
• Uses relationships between several variables. When the user changes any of the input assumptions, a chain reaction often occurs. For example, changing the growth rate will change the sales volume; when the sales volume changes, the revenue, sales commissions, and other variable expenses will change.
• Shows forecasts. Financial models are almost always looking into the future. Financial modelers often want to know what their financial projections will look like down the road. For example, if you continue growing at the same rate, what will your cash flow be in five years?
• Contains scenarios (hypothetical outcomes). Because a model is looking forward instead of backward, a well-built financial model can be easily used to perform scenario and sensitivity analysis. What would happen if interest rates went up? How much can we discount before we start making a loss?

More broadly, a financial model is a structure (usually in Excel) that contains inputs and outputs, and is flexible and dynamic.

Who uses it

Many types of people build and use financial models for different purposes and goals. Financial models are usually built to solve real-world problems, and there are as many different financial models as there are real-world problems to solve. Generally, anyone who uses Excel for the purpose of finance will at some point in their career build a financial model for themselves or others to use; at the very least, they’ll use a model someone else created.

Bankers, particularly investment bankers, are heavy users of financial models. Due to the very nature of financial institutions, modeling is part of the culture of the company — the business’s core is built on financial models. Banks and financial institutions must comply with current regulatory restrictions, and the tools and controls in place are forever changing and adapting. Because of the risk associated with lending and other financial activities, these institutions have very complex financial modeling systems in place to ensure that the risk is managed effectively. Anyone working in the banking industry should have at least a working knowledge of spreadsheets and financial models.

Outside the banking industry, accountants are big users of financial models. Bankers are often evaluating other companies for credit risk and other measures. An accountant’s models, however, are often more inward looking, focusing on internal operations reporting and analysis, project evaluation, pricing, and profitability.

Why it matters

A financial model is designed to depict a real-life situation in numbers in order to help people make better financial decisions.

Wherever there are financial problems or situations in the real world that need solving, analyzing, or translating into a numerical format, financial models help. Sometimes it’s just an idea or a concept that needs to be converted into a business case or feasibility proposal. A skilled financial modeler can put substance to the idea by augmenting the details enough to get a working model upon which decisions can be made, investor funds can be gained, or staff can be hired.

For example, financial models can help investors decide which project to put their money into, an executive track which marketing campaigns have the highest return on investment, or a factory production manager decide whether to purchase a new piece of machinery.

Looking at Examples of Financial Models

When you then consider the benefits that a financial model can bring, it’s difficult not to get carried away thinking of the application potential of a financial model! When you understand the principles of financial models, you can begin to look at the most common scenarios in which a model would be implemented.

There are a variety of categories of financial models:

• Project finance models: When a large infrastructure project is being assessed for viability, the project finance model helps determine the capital and structure of the project.
• Pricing models: These models are built for the purpose of determining the price that can or should be charged for a product.
• Integrated financial statement models (also known as a three-way financial model): The purpose of this kind of model is to forecast the financial position of the company as a whole.
• Valuation models: Valuation models value assets or businesses for the purpose of joint ventures, refinancing, contract bids, acquisitions, or other kinds of transactions or “deals.” (The people who build these kinds of models are often known as deals modelers.)
• Reporting models: These models summarize the history of revenue, expenses, or financial statements.

You’ll see some overlap between each type of model category. For example, many reporting models also contain integrated financial statements, or a project finance model may be used for valuation purposes, but most models can be classified predominately as one model type. Modelers often specialize in one or two of these model categories.

In this section, I show you some examples of scenarios and places in which...